The Federal Reserve Takes Action Against Inflation

On May 4th, the Federal Reserve raised interest rates by 50 basis points and scaled back other pandemic-era economic support as it intensified its fight against the highest inflation we’ve seen in 40 years.

“Inflation is much too high,” Federal Reserve Chair Jerome Powell stated. “We understand the hardship it is causing, and we are moving expeditiously to bring it back down. We have both the tools we need and the resolve that it will take to restore price stability on behalf of American families and businesses.”

This May rate hike marked the sharpest increase from the Fed since 2000 and was the second of what is expected to be six or seven rate hikes in 2022.

Warning Bells Ringing for Investors

In no time, warning bells began to ring, as illustrated by headlines like: “Lookout Retirees, Here Come Rising Interest Rates.” This headline warns us to adjust our investment strategies as bond prices, which move inversely to interest rates, begin to slide.

A Wall Street Journal headline on May 6th declared: “It’s the Worst Bond Market Since 1842. That’s the Good News.” However, the sentence beneath this alarming headline stated, “The four-decade-long bull market in bonds is over, but that doesn’t mean you should dump them.”

The basic premise of these warnings suggests that Federal Reserve rate hikes will hurt bond returns so significantly that investors should reduce their bond allocation. Before taking cover and preparing for the impending rate increases, consider some of the faulty logic that encourages such investment actions.

The Fed’s Influence on Interest Rates

Understanding the Fed’s Role

What’s often misunderstood is that the Federal Reserve does not set or directly control intermediate and long-term interest rates that matter most to bond prices. While the federal funds rate has a strong impact on extremely short-term rates—affecting money markets, bank savings accounts, and floating rate loans—it has much less influence on longer-term rates. The latter are more influenced by bond investors’ trades and market expectations.

Historical Context: Rate Hikes and Bond Yields

For a clearer example of the disconnect between the fed funds rate and longer-term interest rates, let’s look back at the period of Federal Reserve rate hikes that began in June 2004. On June 29, 2004, the day before the Federal Reserve began to raise rates, the 10-year U.S. Treasury yielded 4.7%. Surprisingly, within three months of the first rate hike, the yield on the 10-year bond declined below 4.0%.

In essence, while the Fed increased rates, bond yields went in the opposite direction. A year after the first rate increase, the 10-year Treasury yield remained below 4% despite the fed funds rate rising by two percentage points. Purchasing a 10-year Treasury the day before the Fed started raising rates and holding it for a year resulted in a return of 10.1%. Meanwhile, a 20-year Treasury held over the same period earned 19.2%.

One contributing factor: Back then, China’s government was an eager buyer of long-term Treasuries, driving up their prices and pushing down yields. While that may not be the case today, for many foreign investors, especially amid troubles in Eastern Europe, long Treasuries remain the safe-harbor investment of choice. This challenges the notion that you should avoid bonds when the Fed is increasing rates.

If the market anticipates that Fed rate hikes could trigger an economic slowdown, recession, or simply reduce inflation pressures, expect longer-term bond yields to decrease rather than increase.

Common Fallacies About Interest Rates

Fallacy #1: Higher Interest Rates Will Always Hurt Bond Returns

It’s a fallacy to simply assert that higher interest rates will hurt bond returns. While this belief may hold true in the short term, it doesn’t apply in the longer term. If you buy a 10-year Treasury today and seek the highest nominal return over the next decade, the best-case scenario would be for interest rates to rise dramatically immediately after your purchase.

This logic contradicts traditional short-term thinking, where most people associate rising interest rates with lower bond prices. Yes, the bond price will decline in the short run, and it might seem you would have been better off waiting to buy the bond after rates increased.

However, if rates rise immediately, you will be able to reinvest the coupon payments at higher rates over the next ten years, resulting in a higher holding period return over the bond’s decade-long term than if rates had remained constant or declined.

Fallacy #2: You Should Sell Bonds Before Fed Rate Hikes

Another common fallacy is the belief that you should sell bonds in anticipation of Fed rate hikes. Remember, bond yields are not directly tied to the federal funds rate. Moreover, anyone who sells bonds must find a replacement investment for the sale proceeds.

Cash still yields nearly nothing, and historically, stock prices have provided lackluster results during rate-tightening cycles. Furthermore, predicting interest rate movements has perplexed investors for decades and is likely to continue doing so.

Consider Your Investment Goals

If you believe you clearly understand the future path of interest rates, you may be better off opening a hedge fund to generate substantial profits rather than attempting to make modest gains with your portfolio. Bonds in a diversified portfolio provide crucial protection during stock market downturns.

For instance, while the Standard & Poor’s 500 lost 36.6% in 2008, an investment in 10-Year Treasuries gained 20.1%. If you are more concerned about sharp portfolio losses than near-term fluctuations, maintaining a bond allocation is a better strategy than abandoning this protective asset class.

Final Thoughts: Speculation vs. Investment

What do these misconceptions about rising interest rates mean for you? Humans are inherently biased to take action, a tendency that is not lost on Wall Street. People often prefer action over inaction, regardless of whether the latter is the optimal choice. Since Wall Street profits from investor activity, warnings about rising interest rates and how to protect yourself will persist, as banks and brokerages have a vested interest in encouraging trading activity.

Don’t let public perceptions drive your bond investing. Remember the vital distinction between speculation and investment.

In the words of author Fred Schwed Jr., a stock trader who exited the market in 1929:

“Speculating is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort which should be successful, to prevent a lot of money from becoming a little.”

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